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Interest coverage ratio gives you a picture of how far a company's earnings would have to fall before it was in danger of defaulting on its debt..

The interest coverage ratio calculation shows how easy it is for a company to pay interest on its outstanding debt.

It is calculated by dividing a company's earnings before interest and taxes (EBIT) by its interest expense:

Interest coverage ratio = earnings (before interest and tax)/interest expense

For example, if a company's EBIT totals £500,000 and its interest expense totals £333,000, it has an interest coverage ratio of 1.5.

This means it could make the interest payments on its debt 1.5 times from the cash it generates, giving you an idea of how much of a burden the company's debt load is.

It also gives you a picture of how far a company's earnings would have to fall before it was in danger of defaulting on its debt and is therefore a good gauge of its short-term health.

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Different industries have different levels of acceptable coverage ratios

Look for an interest coverage ratio of at least 1.5. This suggests a company can comfortably afford to pay for its debt.

Most shareholders look for an interest coverage ratio of at least 1.5. This suggests a company can comfortably afford to pay for its debt.

An interest coverage ratio of less than 1 suggests that a company is not generating enough cash to even cover the costs of paying for its debt.

Bear in mind however that different interest coverage ratios are considered acceptable for different industries. It is therefore best used to compare companies in the same sector.

Pay close attention to a company's earnings history

If a company's earnings are consistent, a low interest coverage ratio is less cause for concern.

A low interest coverage ratio is less cause for concern if a company's earnings are consistent. If a company's earnings are volatile however, a low interest coverage ratio can quickly push it into bankruptcy.

If however its earnings tend to swing from year to year – for example a "cyclical" company like a retailer that tends to perform badly during recessions and very well during times of economic expansion – a low interest coverage ratio can quickly push it into bankruptcy. This could see you lose all or most of the value in its shares.

Note that the interest coverage ratio is not a perfect measure of a company's financial health. This is because taxes are not included in the earnings figure used to make the calculation.

Taxes of course are a reality for all companies and they can vary depending on the government of the day.

When you are deciding therefore how much a company's interest coverage ratio might affect its share price, pay close attention to politics.

If a government looks likely to raise taxes on the sector within which a company operates, a low interest coverage ratio for that company should give you greater cause for alarm.

Summary

So far you have learned that...

  • ... the interest coverage ratio calculation shows how easy it is for a company to pay interest on its outstanding debt.
  • ... it also gives you a picture of how far a company's earnings would have to fall before it was in danger of defaulting on its debt and is therefore a good gauge of its short-term health.
  • ... most shareholders look for an interest coverage ratio of at least 1.5. This suggests a company can comfortably afford to pay for its debt.
  • ... interest coverage ratio is not a perfect measure of a company's financial health. This is because taxes are not included in the earnings figure used to make the calculation.
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